Blog – Averting Greek Tragedy

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Despite worrisome signs of increasing intractability in the latest round of negotiations between the Greek government and its creditors, some form of compromise is still the most likely outcome, says Caglar Somek, chief investment officer of the $750 million Caravel Fund.

“Our base case scenario, the one with the highest probability, is compromise” he says, and with Greek government coffers almost bare the endgame is close at hand. In recent weeks, the possibility of “accidental Grexit” has been floated quite frequently in the popular press. And certainly, in the long history of relations between states, what can appear to be the best outcome for all parties is often undermined by lack of trust, a catalog of past grievances or interpersonal problems between leaders. Many would argue that all these conditions apply to the current Greek impasse. However, Somek asserts that a number of important dynamics are still driving compromise. “Despite the media’s desire to personalize the drama, Schauble versus Varoufakis, Merkel versus Tsipras, etc., what should ultimately lead to compromise is naked self interest.”

Ultima Thule Research was lucky to catch up with Somek for an exclusive interview as he returned from a recent investment trip to the region. “The Greeks know that the painful adjustments already endured would be magnified tenfold if Grexit occurs.

While there has already been a big reduction in unit labor costs over the last five years, there are fundamental structural problems in the Greek economy that prevent the export model from being its savior, even with a return to the Drachma. They still need the rest of Europe to help implement reforms.” In addition, on the creditor side, despite talk of a “manageable” Grexit, due to dramatically reduced counterparty risk exposures, the public statements are quite calculated says Somek and are intended to moderate the Greek position. Importantly, contagion is not the sole concern, many participants are wary that the political costs of Grexit could be fatal to the union. “There would be a new ‘n’ of 1 for exit from the Euro, which would prompt a permanent shift in risk calculus. Not only would investors require better returns on peripheral bonds, but serious, perhaps fatal doubt would be cast on the feasibility of the currency union as currently structured”. While a day of reckoning may still come, no one in the current regime wants to be responsible for ushering in that change at a time when Europe’s economic prospects are still shaky. The notion that Grexit could strengthen the union by making “an example” of Greece and hardening the rules for membership underestimates the fallout from a shattered Greek economy and the share of blame that would accrue to EMU authorities, casting doubt on the whole enterprise. After speaking with economists, financial analysts, government officials and multiple political observers, Somek concluded that the current gap is bridgeable and there exists some measure of openness to the Greek position amongst the other 18 members of the currency bloc. “The February 20th agreement already signaled willingness to provide Greece with some flexibility on the primary surplus and the IMF also acknowledged that their multiplier forecasts for Greece were wrong. Bottom line, most capitals in Europe are slightly left of center and there is some sympathy for allowing Greece to help the most vulnerable members of its society. But obviously much of this goodwill has already been squandered and patience is wearing thin.” Is there enough residual goodwill to still come to some agreement? “Yes, and it’s partly a function of how far things have already progressed” says Somek, but it’s also based on “affirming the average Greek citizen’s desire to stay in the EU, as indicated by continued strong polling on this question.”

While Greeks initially gave Syriza high marks for challenging the Troika and restoring some “lost dignity”, the latest University of Macedonia poll highlights an enormous drop in support on the question of whether or not Syriza is pursuing the right strategy in its current negotiations, from 72% in early February to 45% today. This should prove to be a more immediate prod to compromise as the numbers continue to decline. “In the 2012 election Syriza got less traction from Greek voters in part because they were advocating for a return to the drachma. They have since revised a lot of their public pronouncements. In the most recent election, contrary to public perception, overall electoral support for anti-austerity parties was essentially unchanged from 2012, and Syriza’s 9% boost largely came from absorbing the Independent Greeks and the Democratic Left. While there is little love lost for the Troika, the diehard anti-EMU group is only a small faction.” Although it seems inevitable that Greek debt will ultimately be restructured through some combination of rate reduction and maturity extension, right now the cash interest costs on this “unsustainable” burden are far from crippling at roughly 4% of GDP, similar to Germany, but with no payments till 2020. Thus, the crux of the current debate is about the austerity conditions attached to the debt, which is fundamentally a political disagreement. “Huge adjustments have already been made to Greece’s fiscal position, Tsipras has also walked back from debt haircuts, ending oversight and other critical stances” explained Somek about the distance already traveled.

Coming to an agreement on labor and pension reforms, a hike in the VAT and privatization are all extremely difficult given Syriza’s campaign promises, but not insurmountable hurdles in the context of current discussions. With respect to Alexis Tsipras, a hallmark of his career thus far has been “ambition and pragmatism in about equal measure” say Somek. “Given that he is only 41, he still wants to govern for a long time.” An exit from the currency union would make that goal nigh impossible. “He’s still learning on the job, during the March ‘mini-summit’ with Merkel many aspects of wider European politics crystallized for him and the first reform list emerged quite quickly afterward”.

As Michael Lewis wryly observed in the wake of the financial crisis, Greece was virtually the only country in the world where the banks didn’t sink the country, the country sank the banks. With banks again serving as canaries in the coal mine during the current impasse, could a negative but unstoppable chain reaction occur in the banking sector and be a deciding factor in the crisis? “Yes, certainly, but everything is predicated on some form of agreement on the existing program. If that doesn’t happen, then the ELA would likely be pulled, capital controls would be instituted and the strain, especially on private capital, would spell the end of the current government.” Ever since Syriza opted for political expediency in its early days in power and forced a marriage between far-right nationalists and a fractious alliance of leftists there has been talk regarding the formation of a new coalition in order to make some legislative headway.

“Although there has been speculation that a new grand coalition could emerge, with the idea that the Greek people elected Tsipras and not Syriza, the more likely scenario if push came to shove would be a purge of the hardliners within his own party, replaced by moderates from a centrist party like Potami” says Somek. This could be positioned as in the best interests of Greece.

Assuming some compromise can be achieved, what does that imply for equity markets? Somek believes that in the current situation banks could rally 100-200% given that many are trading at half of tangible equity and that “investors would simply look past the 2015 economic numbers and write it off as a lost year”. Most observers would concur, a lost year is certainly more favorable than a Greek tragedy.

Executive Summary

Caglar Somek

Partner & Chief Investment Officer

Caglar Somek has fifteen years of equity research and portfolio management experience with a focus on emerging and frontier markets. Caglar is formerly the CIO of Caravel Management LLC and has also worked for Goldman Sachs Asset Management, Salomon Brothers Asset Management and Credit Suisse First Boston.

Caglar is fluent in Turkish and French, is a CFA charterholder and holds an MA in International Economics and Finance from Brandeis University as well as a BS in Economics from Universite de Paris Dauphine.

Alexander Schay is a Managing Director at Ultima Thule, an equity research company focused on developing markets and an equity partner at WK Associates, a boutique energy consulting firm with a specialization in emerging market oil and gas.

Alex holds both an MS in Risk Management and an MBA from the Stern School of Business at New York University.